VIX Options Explained

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CBOE Volatility Index

Apr 9, 2020, 3:14 p.m.

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    The VIX Explained

    By: Wayne Duggan

    Most traders are aware of the VIX and have at least some vague idea what it represents — market volatility. However, in order to trade VIX-based market volatility, traders must first understand how exactly the VIX tracks market volatility and what types of trading strategies can capture that movement.

    What is the VIX?

    VIX is the ticker for the Chicago Board Options Exchange Volatility Index. The VIX was created in 1993 to measure the implied forward 30-day volatility of the market based on at-the-money put and call option prices for a handful of stocks. Since 2004, the VIX’s implied volatility measure has been based on S&P 500 index options.

    According to the CBOE website, the VIX is calculated as 100 times the square root of the expected 30-day variance of the S&P 500 rate of return. The CBOE website also includes a full list of the formulas used to calculate the VIX for traders that want to learn more. However, the basic gist of the VIX is that it measures the implied forward volatility of the market based on option prices.

    How to trade the VIX

    Unfortunately, it’s impossible to buy and sell the VIX since it is just a measure of options prices and not an actual product in itself. Instead, traders can choose to buy and sell VIX-tracking funds and notes, such as the iPath S&P VIX Short Term Futures TM ETN (NYSE: VXX) and the ProShares Trust II (NYSE: VIXY). The VXX ETN, for example, invests in short-dated VIX futures in an attempt to closely mirror the VIX’s daily movement.

    However, traders need to understand that the constant rollover of short-dated futures contracts leaves the VXX and similar trading vehicles particularly susceptible to contango, which is a long-term price decline due to futures time value decay. The VXX and other products may move closely in tandem with the VIX on a day-to-day basis, but the ETN is down 90.8 percent overall in the past three years due to contango. The VIX itself is down just 18.2 percent in that same period.

    Trading VIX Reversion

    There are many volatility-based trading strategies, but one of the more popular options is trading mean reversion in the VIX. In theory, the average market volatility shouldn’t increase or decrease over time. That theory has historically held true as, since its inception, the VIX baseline has remained in the low teens during the most tranquil market periods and has not exceeded the high teens through most of the market’s more chaotic periods.

    However, when major news events lead to a short-term spike in market fear, the VIX often reacts in kind with large, short-term spikes. Viewing a long-term chart of the VIX reveals that it has drifted mostly sideways for the past 30-plus years, but has spiked repeatedly every time the market gets a case of the jitters.

    Mean reversion traders take advantage of calm periods in the market by going long VIX-linked products in anticipation of the next volatility spike. When it occurs, these traders short those products in anticipation of the VIX quickly reverting to its mean level once market fears subside.

    Lime Brokerage LLC is not affiliated with these service providers. Data, information, and material (“content”) is provided for informational and educational purposes only. This content neither is, nor should be construed as an offer, solicitation, or recommendation to buy or sell any securities. Any investment decisions made by the user through the use of such content is solely based on the users independent analysis taking into consideration your financial circumstances, investment objectives, and risk tolerance. Lime Brokerage LLC does not endorse, offer or recommend any of the services nor information provided by any of the above service providers and any service or information used to execute any trading strategies are solely based on the independent analysis of the user.

    What is the Volatility Index (VIX)

    Usually, when thinking about indices, the first thing that often comes to mind is the DAX, Dow Jones or NASDAQ 100. However, the Volatility Index is quite different.

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    Volatility defined

    The term ‘volatility’ can be explained as a statistical measure that indicates the pricing behaviour of the security or market index and helps to estimate the fluctuations that may occur in a short period of time. In simpler terms: volatility measures how moody the market is or will be in the near future.

    What is VIX?

    The Volatility Index, which is known by its ticker symbol VIX, was developed at the request of the Chicago Board Options Exchange (CBOE).

    In 1992, the CBOE asked Robert Whaley, a professor of management and director of the Financial Markets Research Center at Vanderbilt University, to create a formula that would calculate implied stock market volatility based on prices from the S&P Index options.

    A year later, Whaley computed daily VIX levels dating back to January 1986, based on his algorithms and the CBOE’s historical record of index option prices.

    The VIX is a popular real-time market index, quoted in percentage points, which represents the stock market’s expectation of 30-day forward-looking volatility implied by S&P 500 Index options. Easier explained, the VIX is all about “implied” volatility: it measures how much traders and investors are ready to pay to sell or buy the S&P 500. The index is a registered trademark of CBOE.

    The VIX serves as a contrarian mood indicator, helping to determine whether there is too much fear or confidence in the market. Typically, at the point when the sentiment reaches one extreme or the other, the market is inclined to reverse.

    Coronavirus affects markets

    In times of political uncertainty and economic crises, the VIX tends to surge. This fact has given the CBOE Volatility Index its bynames like the “fear gauge” or the “fear index”, as it is viewed by many as a market anxiety and fears measurement.

    Investors and traders, as well as portfolio managers and research analysts, suggest taking into consideration VIX values to determine market risk, fear and stress when taking investment decisions.

    Despite the fact that the VIX might or might not be a thorough protection from risk, traders still prefer to check this indicator from time to time to measure the direction of the attitudes towards the market and the possible path of short-term trading. As a financial indicator in its own right, the CBOE Volatility Index can be used as a means towards gains or the protection of portfolios.

    How does the VIX work?

    Traders and investors tend to buy options in order to protect themselves from the downside risk when anticipating a possible market fall. As they purchase these, the implied volatility rises, and that, in turn, raises the value of the VIX – and vice versa.

    Traders who are looking for ways to incorporate the VIX into their portfolios have a number of alternatives to choose from. For example:

    VIX Explained

    Now, the Chicago Board Options Exchange (CBOE) introduced the first exchange-traded VIX futures contracts back in 2004. Just 2 years later, CBOE introduced VIX options. Consequently, this allowed sophisticated traders the ability to trade and potentially profit off of volatility. The VIX Index uses a mathematical formula to come up with a value. Don’t worry, we won’t be going over Ph.D. level math here.

    You just need to understand that the VIX Index is comprised of options, not stocks. You see, options have a volatility component, unlike stocks. Option’s prices reflect the market’s expectation of future volatility. Now, if you don’t know anything about options, don’t worry – you can learn options trading in as little as 30 days with this guide.

    VIX Could Have Abnormal Moves

    The VIX Index serves as a barometer for the expected volatility of the S&P 500 Index over a 30-day period. The VIX components include near- and next-term puts and calls with at least 23 days, but less than 37 days, until the expiration date. The options are also out-of-the-money S&P 500 Index (SPX) calls and puts, which are centered around the at-the-money strike price. Keep in mind, when this volatility in the markets, the calculations of the VIX could get out of whack.

    For example, we saw how crazy VIX got back in February 2020.

    The VIX spiked over 200% in just a few days. Those who were short volatility didn’t see this extreme event coming.

    However, if they had seen this indicator, maybe they would’ve been able to prepare for the spike in volatility.

    When you’re learning how to trade VIX products, understand that volatility has unlimited upside potential. In other words, volatility could spike and move extremely just as it did in 2020. Additionally, volatility is often thought to be a mean-reverting asset. However, that doesn’t mean volatility can’t stay high for a long period. That said, there are ways to profit off of crashing stocks and volatile markets.

    This brings us to VXX.

    iPath S&P 500 VIX Short-Term Futures ETN (VXX)

    Take note – VXX is maturing on January 30, 2020. That said, this volatility product will no longer be traded after that date. Barclays – the exchange-traded note (ETN) issuer – will conduct the final valuation for VXX the day before the maturity date.

    Now, if you’re long VXX and want to figure out what to do with your shares, check it out here.

    Moving on. VXX was one of the first ETNs that provided exposure to S&P 500 Index volatility. VXX trades like a stock, with a bond component. You see, VXX could have been bought, sold, or sold short during pre-market, market, and post-market hours. This ETF was trading with an average daily volume of over 70M shares a day – making it extremely liquid with tight bid-ask spreads. Additionally, VXX had options available. However, unlike a stock, VXX had a maturity date. In other words, it had an expiration date – which was set just 10 years from its issue date.

    Now, VXX was designed to track the daily percentage changes in the VIX. That said, this product was the life blood for many volatility traders for many years.

    Heck, I was able to generate profits like these in VXX options.

    If you look above, I was able to put on bull call spread trades on VXX.

    Moreover, I was able to generate profits placing directional bets on the VXX, as shown above. Now, if any of these options trading terms sound unfamiliar to you, make sure to learn the basics of options here if and when you decide to trade VXXB options.

    This brings us to VXXB. Since VXX ceased trading on January 30, 2020, Barclays introduced VXXB to the market that is more or less the same as VXX.

    iPath Series B S&P 500 VIX Short-Term Futures ETN (VXXB)

    Now, VXXB is very similar to VXX. VXXB’s maturity date is 30 years from the day it commenced trading – much longer than VXX’s 10-year life span. However, that doesn’t mean Barclay’s cannot decide to call the ETN, causing it to cease trading, before the maturity date. We’ve already seen this with XIV, that’s why it’s never a good idea to hold ETNs for extended periods.

    Currently, VXXB has relatively low volume, when compared to VXX – trading 1.1M shares per day on average, while VXX has an average daily volume of 45.68M. However, once VXX ceases to exist, VXXB should see an influx of volume – making it liquid with tight bid-ask spreads.

    Check out the hourly chart of VXX.

    Now, take a look at the hourly chart of VXXB.

    Looks pretty similar right? However, look at the volume bars on VXXB. You can see volume already picking up in this ETN.

    VXXB Trade Example

    If you’re wondering how you can profit from volatility, make sure to check out this eBook. Now, to trade VXXB, I like to use VVIX, which measures the volatility of the VIX. In other words, it gives me an idea of when volatility could pick up.

    However, what I like to use most is the money pattern. I simply wait for a crossover.

    For example, I saw this in VXXB not too long ago.

    Here’s a look at the hourly chart of VXXB.

    Once the blue line (13-period simple moving average) crossed above the red line (30 SMA), it signaled I should be looking to get into calls… which I did. In just a few days, I was locking in $50.75K in VXXB. Heck, I let Weekly Money Multiplier members know about my moves too.

    That said, trading VXXB could be profitable if you know what you’re looking for.

    Final Thoughts on VIX Trading

    The VIX is a barometer for market volatility, and lets traders know the sentiment of the market. You can gain exposure to the VIX through options, VXXB, or VXXB options. Now, when stocks are crashing, you’ll notice VIX and VXXB will catch a strong move higher. On the other hand, when the market is grinding higher, volatility is low – causing for VIX and VXXB to be at relatively low levels. If you’re interested in learning about my trades shown earlier, check out this webinar.

    One of the best traders anywhere, over the past 20 years Jeff’s made multi-millions trading stocks, ETFs, and options. He is renowned as an incredible trader with a deep insight and a sensitive pulse on the markets and the economy. Jeff Bishop is CEO and Co-Founder of

    Even greater than his prowess as a trader is his skill and passion in teaching others how to trade and rake in profits while managing risk.

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